Liam Croke: Be prepared for potential rise in the interest rate

Janet Yellen is a name unfamiliar to most people, but is someone we will get to know well. Why? Because what she is going to do in the coming months will have an impact on all of us in the years ahead.

Janet Yellen is a name unfamiliar to most people, but is someone we will get to know well. Why? Because what she is going to do in the coming months will have an impact on all of us in the years ahead.

She is chair of the Federal Reserve in America, and signalled earlier this year that in September the Fed was likely to raise interest rates by 0.25% with another increase coming again in December.

The increase due in September didn’t materialise because of what happened in China, and the Americans wanted to wait and see how the slowdown in China’s economy was going to affect them.

It seems the impact was not that much because with higher than expected job creation and unemployment down at 5%, the Fed is now ready to act, and act it will in December.

All indications are that the increases will be small and steady rather than big, once-off rises.

The Fed has kept interest rates at about 0.25% since the financial crisis began back in 2008, and the Bank of England kept its rates low as well (currently at 0.50%).

They, along with the ECB and other Central Banks around the world, were doing this to support economic growth and help bolster their economies. With improvements in the labour market, their economies growing strongly, and jobless figures falling, the Fed and the BOE want to move rates back to more normal levels.

So, what does all this mean for us and our personal finances? If rates increase in other areas of the world, but the ECB does nothing, surely we are fine, aren’t we?

We will be for a time, and the ECB is unlikely to increase rates in the short term but it will be only a matter of time, before they do. The Germans in particular have made no secret of the fact that their Central Bank, the Bundesbank, has been pressing the ECB for higher Eurozone interest rates to prevent their economy from over-heating.

We have become accustomed to nearly a decade of incredibly low interest rates, and some have taken this for granted and think it will always be like this. But think again.

For some, an increase in rates will be welcome, particularly those with very little debt who have money on deposit earning very little. Others will dread the increase because the cost of servicing mortgages and personal loans will increase.

What I want to look at in this article is what an interest rate rise will mean to you.

Borrowing costs will rise

Interest rate increases will increase the cost of borrowing for new and existing mortgage holders and anyone borrowing money for whatever reason like purchasing a car, renovating their home etc...

There are about 300,000 mortgage holders who have a variable interest rate and 375,000 who have a tracker and everyone one of them will be affected when interest rates increase.

Weirdly, the effect of an increase in rates has a bigger impact on those who have a lower rate than those who are on a higher rate.

Let me explain further; according to the Central Bank, the average tracker rate in Ireland for owner occupiers is 1.05% and it’s 4.26% for variable rate holders.

If you had a 25-year tracker mortgage and you owed €250,000, your monthly repayment would be €947.85. If rates increased by 1%, then your new monthly repayment would be €1,065.73, an increase of €117.88.

If you had a variable rate mortgage where you paid the same €947.85 each month, then you would owe about €175,000. If rates increased by 1% from a base of 4.26% then the effect on this monthly repayment would be €1,049.72, an increase of €100.70.

If you have a variable rate it might be worth giving serious thought to switching to a lower fixed rate, especially if an increase of 1% was going to put a strain on your monthly cash flow.

Or, switch to a provider offering a lower variable rate, because, the savings achieved now will cushion that increase when it happens.

An example of this occurred last week with a client who has a variable rate mortgage with BOI paying €1,043 per month at a rate of 4.49%.

If rates increased by 1%, her monthly repayment would increase to €1,134. If she locks into a five-year fixed now, her new monthly repayment would be €993.40, which is less than what she is currently paying and considerably less when rates increase.

If switching to a fixed rate is not for you or you don’t want to or can’t move lenders, then consider repaying your mortgage as if rates increased by 1%.

Continue to pay your current repayment but if a 1% increase was for example €70, then build this amount into your monthly budget and put it into a savings account.

By doing this, when rates do increase it won’t be as big a shock to your system because you will have been used to repaying the higher amount and you will have increased your savings in the process.

Money on deposit will earn higher returns

You would like to think it will. Because, even if rates do increase our banks may not be in a rush to pass on the full increase to savers right away.

But when rates do go up, the real winners are those who have money on deposit. Given how poor rates have been for such a long period of time, coupled with a punitive DIRT tax rate, it’s about time savers were rewarded.

What some investors and those who hold pension funds have to be on the lookout for is the value of corporate and government bonds. Typically the value of these investments - which are basically a fixed interest investment where a government will pay a coupon (fixed rate) each year for the use of your money - will decrease in their capital value when interest rates increase, unless the coupon matches what’s available elsewhere on the market.

So, it might be time to start reviewing the percentage you hold in bonds within your pension fund, and for those who have money sitting on deposit earning very little or have funds about to mature, I would hold off re-investing them at fixed rates, particularly for periods in excess of three years for a little while yet, because you could be locking in at a low interest rate now and not benefiting when rates do rise.